Wednesday, October 21, 2009

Price Levels and Market Breakouts

My recent post noted a "multiday trading range". There's nothing mysterious about such ranges; the relative highs and lows within those ranges are pretty much on the radar for most traders and portfolio managers. The more times we touch a relative high or low in a range, the more important those "levels" become for traders. Breaking those levels can lead to a surge in buying or selling, as stops placed at obvious levels are taken out. Knowing where those levels are at--and where stops are likely to be placed--can lead to profitable short-term trades.

A nice example occurred this afternoon as part of the market's selloff. We saw expanded volume on the selloff (top chart), which told us that large traders were participating to the downside. As that continued, I began looking at the 1076 area as an important level, as it defined the lower end of the multiday range (bottom chart). Knowing that selling momentum/volume was sustained and knowing that stops were likely to be placed just below that level led to a nice trade where sellers could hold their positions through that stop point.

Observe (top chart; blue arrow) how volume swelled tremendously as we broke the support level. A canny trader can anticipate such "puking" and craft short-term breakout trades around those levels.

Going forward, whether we can sustain prices back above the 1076 region vs. see that support area now become resistance will frame the issue of whether today's selloff is the start of a trend reversal. Traders who believe that might be the case can hold onto positions (or portions of positions) through the short-term breakout to hit more distant profit targets.